IMF looks ahead to Latin America’s challenges

In April the International Monetary Fund (IMF) published a “Discussion Note” which looked at the challenges a new era of abundance is already imposing on Latin America. Of course, there has been something of a mood shift in global markets between April and June, with April’s optimism in almost headlong retreat in the face of a spate of bad news from the US and European markets, and continued inflation in emerging markets. The US indexes have been falling for six weeks on the trot, giving up a large chunk of recent gains, all of which casts a shadow over the assumption that the emerging, resource-rich economies of Latin America are going to continue to enjoy booming market conditions.

Nevertheless, the IMF paper was smart enough to look ahead to what might happen, or what difficulties might present themselves to Latin American markets in the face of sudden market shocks. This, indeed, was part of what the paper was all about, so it is still very relevant.

The paper is titled: “Managing Abundance to Avoid a Bust in Latin America”. It’s starting point is neatly summarized in the paper: “Exceptional global circumstances have produced a double bonanza of easy foreign financing and high terms of trade for Latin America (LA), particularly for commodity exporters—favorable conditions that will not last forever. Managing this abundance will be critical to avoiding a boom-bust cycle.”

The appeal of developing economies

With central banks still setting very low interest rates for developed economies, investors in those economies are getting a negative return on cash and low-risk cash equivalents, after inflation is taken into account. This predisposes investors to look for higher yielding assets and emerging markets generally are seen as offering much better returns than developed markets. At the same time the fundamentals in emerging markets, namely younger populations, more rapid growth, the momentum towards further industrialization, all make those markets a safer bet than the debt-ridden developed markets. So, with investors both being more tolerant of risk and with emerging markets looking like the better bet anyway, there is a veritable wall of money flowing towards those markets, with the resource-rich countries of Latin America coming in for a major share of those monies.

However, this is not a set of circumstances that will endure forever. The IMF points out that if advanced economies start to shake off the recession and can generate strong growth, much of that outbound capital flow that is finding its way to Latin America could flow back home with little or no warning. Latin America is also enjoying strong demand for its goods from multiple sources, which means that companies are, to some extent, in control of their pricing and are able to set much more favorable terms of trade than would be the case in tougher conditions. All of this constitutes the current bonanza that Latin America is enjoying.

Blowing an economic bubble?

What the IMF authors desperately want to see is some signs that governments in countries like Brazil, Argentina and Venezuela are aware of the vulnerabilities that the good times are creating in their economies, and that they realize that the boom years are masking what the authors term “underlying fragilities in external, financial and fiscal accounts”. There are all the hallmarks of bubble conditions and it would be very easy for the financial sectors in these economies to play an amplifying role in any credit or asset bubbles that might be forming.

Latin American governments have some powerful tools at their disposal to counter this. In particular the fact that countries are in control of their own exchange rates, which is more than can be said for countries in the European Union, gives them considerable flexibility to dampen down the incentives for capital inflows. Brazil, for example, is already imposing penal taxes on capital investments from abroad. As far as fiscal policy is concerned, the IMF wants to see all signs of stimulatory QE style stoking of Latin American economies halted immediately. “Fiscal policy needs to be acyclical, undoing recent stimuli and saving temporary revenue gains,” it says. And of course the whole region needs to stay on top of macro-economic prudential policy.

It won’t be easy. Corporates can bypass domestic macro-prudential policies and domestic financial institutions, creating excess current account deficits in the process. However, if policy makers stay on their toes, Latin America could end up benefiting from the boom without suffering the horrendous consequences of an outsized bust to follow. Where was all this sage advice while advanced economies were throwing their six year long party, one wonders...

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